China Considering Ditching US Treasuries

A day after Bill Gross called bonds a bear market[1], reports are out that the Chinese government is considering slowing our halting US Treasury purchases[2]. While it's easy to connect the dots between this potential change and anti-trade rhetoric from President Trump - which, to date, has thankfully been more bark than bite - the larger issue is central banks are slowly backing away from policies that have inflated bond markets. It's a good time to re-vist an article by Thornton Polleit titled "The Super Bubble Is in Trouble":

First and foremost, the US economy appears to be addicted to cheap money. The latest economic recovery has been orchestrated, in particular, through a hefty dose of easy monetary policy. It is therefore fair to assume that market agents will have a hard time coping with higher interest rates. For instance, corporations, consumers, and mortgage borrowers, in general, will face higher credit costs and a less favorable access to funding if and when interest rates edge higher.

In particular, higher interest rates could send the inflated prices of stocks, bonds, and housing southward. For instance, expected future cash flows would be discounted at a higher interest rate, deflating their present values and thus market prices. The deflation of asset markets would hit borrowers hard: Their asset values would nosedive, while nominal debt would remain unchanged so that equity capital is wiped out — a scenario most investors might assume to be undesirable from the viewpoint of central banks.

Moreover, the yield curve has become flatter and flatter in recent years. This, in turn, suggests that banks' profit opportunities from lending have been shrinking, potentially dampening the inflow of new credit into the economic system. A further decline of the yield spread could bring real trouble: In the past, a flat or even inverted yield curve has been accompanied by a significant economic downturn or even a stock market crash.

That said, investors might expect that central banks find it hard to bring interest rates back up, especially back to a level where real interest rates are positive. This holds true for the Fed as well as for all other central banks, including the ECB. This is because the monetary policy of increasing borrowing rates by a significant margin would most likely prick the “Super-Bubble” which has been inflated and nurtured by central banks’ monetary policies over the last decades.

However, it wouldn’t be surprising if, again, central banks, the monopolist producers of fiat money, turn out to be the major course of trouble. After many years of exceptionally low interest rates, central banks may well underestimate the disruptive consequences an increase in borrowing rates has on growth, employment, and the entire fiat money system. In any case, the artificial boom created by central banks must at some point turn into bust, as the Austrian business cycle theory informs us.

The boom turns into bust either by central banks taking away the punchbowl of low interest rates and generous liquidity generation; or the commercial banks, in view of financially overstretched borrowers, stop extending credit; or ever greater quantities of fiat money need be issued by central banks to keep the boom going, inflating prices so that ultimately people start fleeing out of cash. In such an extreme case, the demand for money collapses, and then a Super-Super-Bubble pops.

As Troy Vincent, a market analyst and Mises Wire contributed, offered an additional note this morning on Facebook:

The fact that Bitcoin didn't get bid up in response to this news, while treasury yields and physical gold did, is pretty interesting.